Thursday, July 15, 2010

An Overseas Asset Buying Spree?

Canadian pension funds are crisscrossing the globe with cash in hand in search of assets for revenue to support this country’s aging population.

One place they’re looking is foreign infrastructure assets, according to the Canada Pension Plan Investment Board’s senior vice president of private investments Andre Bourbonnais.

Infrastructure assets - such as electricity generation, water distribution and airports - are easy to operate and maintain, generate predictable cash flows, offer protection against inflation and can be owned for a very long time, Bourbonnais told QMI Agency Thursday.

“There’s not a lot of complexity in operating a toll road for instance,” he said.

Late Wednesday, the CPPIB revived its bid for Australian toll road operator Intoll Group with a $3.5-billion offer. The Sydney-based company also owns a minority stake in Toronto’s 407 electronic toll highway.

In May, the CPPIB snapped up a minority share in two prime Manhattan buildings for $663 million.

And last year it was part of the largest leveraged buyout of 2009 — the $4-billion acquisition of IMS Health Inc, a prescription drug sales data provider.

The Ontario Teachers Pension Plan has also been on a foreign buying spree after recently picking up U.K. state lottery Camelot for $536 million.

The teachers' fund has also tried to up its share of Australian toll road companies Intoll and Transurban in recent months.

And there have been reports the teachers, along with Ontario MunicipalEmployees Retirement System, could be involved in a multi-billion dollar bid for a U.K. high-speed rail franchise.

The CPPIB launched its aggressive infrastructure investment plan roughly five years ago.

“We’ve been looking globally at infrastructure assets,” Bourbonnais said, adding policy conditions in Australia and the U.K. are quite favourable right now.

Bourbonnais said the fund will likely pursue other deals with similar characteristics as Intoll.

“The predictability of the return and long-term ownership of those assets fit well with our mandate,” Bourbonnais said.

The CPPIB has assets totalling $127.6 billion after funds returned to pre-recession levels earlier this year.

Today, the CPPIB receives more contributions from working Canadians than it pays out in benefits. But that is expected to reverse by 2021, when Canada’s workforce is expected to shrink to new lows and the elderly population explodes.

In the 1990s, the CPPIB began to diversify its holdings, moving into equities, public properties then private spaces. Before then, the fund only invested in government bonds.

Today, the CPPIB generally operates with the rationale that the right mix of private assets can perform better than public ones in the long run.

Why is this important? Because unlike fully funded plans, it's investment process doesn't center around matching assets with liabilities. CPPIB can take on more long-term risk in illiquid assets if it feels there are compelling reasons to be investing in these assets.

My last precondition for acting as a long-term investor perhaps states the obvious, and that is that your investment process actually has to incorporate long horizon valuation factors.

As obvious as this may sound, relatively few investment processes actually operate this way. In addition to the points already noted, another simple reason is that investment managers who are measured, rewarded, and can be hired/fired over increasingly short periods are not likely to build investment processes that identify valuation anomalies that may take 5 years to materialize.

In practice it means that those managers aren’t likely to buy real estate in a falling market with the expectation that they will have to mark it down in the near term even though its risk adjusted returns over a ten-year timeframe may be compelling – it’s also worth pointing out of course that those real estate assets are not necessarily for sale when times are good.

It means investors won’t likely defer receipt of current dividends from an infrastructure asset for example in order to instead re-invest to improve the efficiency or capacity of the asset to generate future returns. And it means that such managers are not likely to invest resources into researching and identifying long horizon factor models that are different from most standard investment programs.

Another reason why CPPIB and other Canadian pension funds are snapping up global real estate and infrastructure assets? Look at the appreciation of the Canadian dollar over the last year (chart above versus USD but CAD has also appreciated versus the Euro). The strong CAD makes these foreign assets a lot cheaper, allowing these mega funds to snap up assets on the cheap using a strong commodity currency.

But there are other reasons why large Canadian funds are investing in infrastructure. In the last six years, infrastructure has become a hot asset class, appealing to long-term investors looking to match duration of their long-term liabilities with high quality assets providing steady cash flows. Also, the effects of the liquidity crisis have been minimal on infrastructure assets.

Finally, despite its attraction, infrastructure does carry risks, but it can also serve to mitigate portfolio risk. In late May, Samuel Sender, senior researcher at Edhec-Risk Institute, wrote an excellent op-ed in the FT, Pensions falling short on risk management:

News of huge pension deficits and closures of defined benefit pension funds suggest that risk management by pension funds may not be entirely up to scratch. To examine the issue of risk management practices, Edhec-Risk Institute recently surveyed pension funds, their advisers, regulators and fund managers.

An initial finding of the survey, conducted as part of the Axa Investment Managers research chair at Edhec-Risk Institute, is that most of the 129 respondents have a restrictive view of the risks they face. Prudential risk (the risk of underfunding) is managed by only 40 per cent of respondents; accounting risk (the volatility from the pension fund in the accounts of the sponsor) by 31 per cent; and sponsor risk (the risk of a bankrupt sponsor leaving a pension fund with deficits) by less than 50 per cent.

A primary challenge for a pension fund is to meet its liabilities by hedging the liability risk away, usually with what is known as a liability-hedging portfolio, the portfolio that best replicates liabilities. Pension funds generally hedge their interest rate and inflation risks. Since it is mandatory in the UK to index pension payments to inflation, British pension funds are more likely to use inflation-linked bonds (64 per cent of respondents from the UK have more than 20 per cent of their liability-hedging portfolio in inflation-linked securities).

However, the excessive demand for inflation-linked securities may lead to poor returns on inflation-linked bonds, making the liability-hedging portfolio expensive. For that reason, pension funds may seek to replicate liabilities with assets that can provide better returns, such as real assets. On the other hand, our survey suggests 45 per cent of pension funds do not fully model the liability-hedging portfolio at all. This turns out to be logical in that 46 per cent of respondents use optimisation techniques to achieve the best risk/return trade-off.

A second challenge for pension funds is to achieve positive returns.

This can be done through a performance-seeking portfolio that diversifies market risk in an optimal manner by using a mix of asset classes and an appropriate benchmark for each asset class (we find that 81 per cent of pension stakeholders use sub-optimal market indices as benchmarks for their investment funds).

Equities account on average for 32 per cent of the performance-seeking portfolio, a share that is much larger than that of potentially illiquid assets (hedge funds, private equity, and infrastructure), even though pension funds, as long-term investors with no need to worry about short-term liquidity, are in a good position to invest in these assets and take on liquidity risk.

Risk-controlled strategies, which insure against a fall in funding ratios below the required minimum, make it possible to forgo some of the upside potential of the performance-seeking portfolio in exchange for downside protection.

Curiously, 50 per cent of pension funds are fully aware of these strategies, but only 30 per cent use them.

Economic capital management (seeking to ensure funding ratios always remain above a minimum level) relies on a risk budget and a surplus, but it involves a discretionary investment strategy and possible delays in implementation. Since the use of economic capital means a liability-hedging portfolio (the risk-free portfolio in an asset-liability management setting) does not need to be set up, pension funds may find themselves unable to switch their investments quickly to this risk-free portfolio.

Unlike this discretionary approach, applying risk-controlled strategies to economic capital creates what might be called rule-based economic capital, a strategy that would compel pension funds to manage economic capital with less discretion and greater adherence to pre-defined rules. After all, simple rules similar to those of constant proportion portfolio insurance ensure that risks are covered.

Finally, pension funds generally do not assess the adequacy of their asset-liability management strategies or fail to do so with appropriate metrics: 30 per cent of respondents do not assess the design of the performance-seeking portfolio, and more than 50 per cent use relatively crude outperformance measures.

These shortcomings may mean that less than optimal decisions are made on an ongoing basis.

Less optimal decisions are made on an ongoing basis, but Canadian pension funds are taking a more global approach to mitigating risk. The recent overseas buying spree by Canada's largest pension funds may indeed prove to be a wise decision, but infrastructure assets aren't a panacea, and they do carry important risks. We shall see if these long-term investments deliver on what investors expect from them.

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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